Stock Market Indices

Stock Market Index is a composition of multiple equity shares, that is representative of the stock market or a segment of it. The most tracked broader market indices of India are Nifty 50 of National stock Exchange & S&P BSE Sensex of Bombay Stock Exchange. The purpose of an index is to denote all the companies listed on the exchange (or a subset of it), by a single numerical figure. It allows for comparison of value of the listed companies (read businesses), as well as investing sentiment of whole mass of people participating on the exchange.

Nifty 50 Index is composed of 50 of the 1600 companies traded on the NSE. The base date of the index is November 3, 1995 (1st anniversary of the NSE) & the Base Value is 1000 with a Base Capital of Rs 2.06 trillion. The level of the Index reflects the total market value of all the stocks in the Index relative to the base period November 3, 1995.

• Index Value = (Current Market Value / Base Market Capital) * Base Index Value

The index started trading in April 1996. From 2009, the index was created using the float-adjusted market capitalization-weighted method. The measure of shares that are freely available for trading out of total shares is called IWF.

• Market Capitalization = Shares Outstanding * Price
• Free Float Market Capitalization = Market Capitalization X IWF

Stocks with highest free-float market cap carry highest weight in index. Approximately, 65% of the weightage in Nifty 50 Index is that of top 10 stocks.

S&P BSE Sensex is a free-float market-weighted index of 30 companies listed on Bombay Stock Exchange.

Making sense of Market Valuations

The judgement calls on market valuation – whether the companies on composite basis are expensive or cheap – may have different perspectives but the top-down fundamental approach would be as follows:

Assumptions:

1. Long-term valuation of a steady market should be at Nominal GDP Growth% – if Real GDP Growth is 7%, Inflation is 5% then Nominal GDP Growth% = 12%
2. At steady state equilibrium, corporate profits as % of GDP stays same. Additional Return due to efficiency of companies in Nifty 50 Index is 3%
3. Corporate Earnings Growth = 7% + 5% + 3% = 15%
4. Stock markets are forward looking – say, factors in  next 3 years of earnings.
5. Trailing PE ratio of Nifty 50 Index = 32

Judging Market Valuations:

One perspective on judging market valuations is that market is forward looking & valuation of the market incorporates whatever earnings growth it is expecting from corporate sector, in the near future. Comparing expectations built in against the actuals would give a fresh direction to the market.   

1. Nifty 50 Index PE = Nifty Price / Nifty Earnings = 32 times trailing earnings
2. Rs. 100 of current corporate earnings (last four quarters) is available at Rs. 3,200 (Nifty PE * Nifty EPS = 32 * 100).
3. For current valuations of Nifty 50 Index to hold, Corporate Earnings should be  = Valuations / Earning Growth% = 3,200/15 = 213
4. Thus, Corporate Earnings should grow = (213 -100) / 100 = 113%
5. So, Current Nifty 50 Index is factoring in growth in Nifty 50 EPS @ CAGR% (compounded annual growth) = 113% over 3 years = 28.64%.

A more conservative approach would be making a realistic projection regarding the corporate earnings expected to grow in, say next 3 years. Based on such projection, market valuations could be arrived at that best justifies the state of health, corporate sector is in.

1. Assuming conservative estimate of corporate earnings growth for 3 years ahead at 12%.
2. Corporate Earnings should grow from 100 to 140 in 3 years.
3. Taking long term average of Nifty 50 Index PE of 20 as reference point.
4. Nifty 50 Index valuation should be 20 * 140 = 2,800 (at forward outlook of 3 years) against the current valuation of 3200.
5. Say, Nifty 50 Index is currently at 15,750, for a conservative investor, valuation should be (2,800 / 3,200 * 15,750) = 13,781. So, possible fall in the market could be (15,750 – 13,781) / 15,750 = 12.5%.